Economic Survey of Japan 2009: The fiscal policy response to the crisis and achieving fiscal sustainability

The following OECD assessment and recommendations summarise chapter 3 of the Economic Survey of Japan published on 30 September 2009.

Contents

With the ballooning of the budget deficit in the wake of the crisis…

The reduction in the budget deficit – from 8.2% of GDP (excluding one-off factors) in 2002 to 3.2% in 2007 – is rapidly being reversed, putting the target of a primary budget surplus for central and local governments by FY 2011 out of reach. Gross government debt is projected to rise to 200% of GDP in 2010, and to 100% in net terms, raising serious concerns about the sustainability of the fiscal situation. It is essential, therefore, to develop a credible and detailed medium-term fiscal consolidation programme to maintain the confidence of financial markets and to implement it once an economic recovery is firmly in place. The December 2008 programme to upgrade the social welfare system would make fiscal consolidation even more challenging as it implies increasing public social spending from its current level, which is below the OECD average, making the required rise in revenues even larger.

The budget deficit and the public debt ratio are increasing rapidlyFor general government, as a percentage of GDP(1)

Japan’s gross and net public debt are high compared to other OECD countries(1)

1. The five countries with the highest gross debt ratios in the OECD area in 2000.
2. OECD estimates for 2008 and projections for 2009-10.Source: OECD (2009b), OECD Economic Outlook, No. 85, OECD, Paris.

…the previous government established fiscal targets…

In June 2009, the government set out new targets for fiscal consolidation: stabilising the public debt ratio by the mid-2010s and putting it on a downward trend from the early 2020s. This was to be accomplished by halving the primary budget deficit of central and local governments by FY 2013 and achieving a surplus by FY 2019. It is essential that a more ambitious fiscal consolidation objective be adopted to limit the run-up in debt and the risk of higher interest rates. Japanese interest rates have remained surprisingly low and stable despite rising public debt, reflecting abundant domestic saving, significant home bias and consistently large purchases of government bonds by financial institutions in a context where attractive domestic investment opportunities are limited. Looking ahead, the conditions fostering low interest rates are likely to weaken. For example, the new Japan Post Bank and the national pension funds may expand their investments in other assets. An effective fiscal consolidation programme is thus essential to limit the risk of a substantial rise in interest rates. Moreover, given the objective of reducing the public debt ratio, it is important to shift the focus of consolidation from the primary to the overall budget balance.

…that require expenditure reductions,…

Cutting expenditures should play an important role in achieving the fiscal targets. After falling from 39% of GDP to 36% during the 2002-07 expansion, public spending is projected to reach 42% in 2010. The decline in public investment, from 8.4% of GDP in 1996 to 4.0% in 2008, was partly reversed by the fiscal stimulus packages. Unwinding this increase would reduce total spending by almost 1% of GDP. Cuts in investment should be accompanied by better allocation to enhance its productivity. The cost of maintaining existing infrastructure is projected to exceed new investment by 2011 and completely crowd it out by 2022. Maintaining scope for productivity-enhancing public investment thus requires closing under-utilised infrastructure, based on strict cost-benefit analysis in the context of a declining population. There is also room for further cuts in the government wage bill as hikes in public-sector salaries have far outstripped those in the private sector during the past 15 years. Efforts to scale back the wage bill should be focused on local governments, public enterprises and government-affiliated organisations, which account for more than 90% of public-sector employment. In any case, the scope for expenditure cuts in this area is limited by the small size of Japan’s public sector relative to other major OECD economies.

Public investment in Japan, as a share of GDP, is still above the OECD average

Source: OECD (2009b), OECD Economic Outlook, No. 85, Paris, OECD.

…revenue increases, mainly from the general consumption tax…

Given the limited scope for spending cuts, achieving the fiscal targets will require additional revenue, preferably through a fundamental reform of the tax system, as outlined in the 2008 Survey of Japan. Such a reform should boost revenue, while limiting the negative impact on Japan’s growth potential, addressing concerns about income inequality and relative poverty and improving the local tax system. The key elements of such a reform would include:

A hike in the consumption tax rate should be the main source of additional revenue, as it limits the negative impact of higher taxes on economic growth.

Broadening the corporate tax base, thereby lowering the proportion of firms that do not pay tax, would provide scope for cutting tax rates, which would spur economic growth.

Broadening the personal income tax base would also raise needed revenue, given that less than half of wage income is taxed and the self-employed under-pay taxes. Reform of the income tax should include the introduction of an earned income tax credit to address the issues of income distribution and relative poverty.

Improving the local tax system, which is exceptionally complicated with 23 taxes, and allowing more fiscal autonomy to local governments would be beneficial.

The previous government proposed to allocate all consumption tax revenue to social security. Although earmarking may make it politically easier to raise the consumption tax rate, it could also limit flexibility in spending.

…and ensuring the long-run sustainability of the pension system

Controlling public pension spending in the face of rapid ageing is essential to reduce the public debt ratio. The 2004 reform aims at ensuring the sustainability of the pension system for 100 years by introducing “macroeconomic indexation”. This is projected to reduce the benefit replacement rate from 62% to around 50%. It also involves raising the contribution rate from 13.6% in FY 2004 to 18.3% by FY 2017 and increasing the government contribution to the basic pension from one-third to one-half in FY 2009. As the long-run projection is sensitive to economic and demographic assumptions, additional reforms may become necessary in the future. In that case, rather than further raise the contribution rate or lower the replacement rate, the best option would be to further increase the pension eligibility age, which under current plans will reach 65 by 2025 for men and 2030 for women. Other reforms are needed to limit the negative impact of the pension system on labour supply. In particular, the exemption from contributions to the pension system, as well as for health and long-term care, for second earners in households with an income below a certain threshold encourages them to restrict their working hours.

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